Enterprise Risk Management Shaun Wang, Ph.D., FCAS, ASA Director of Actuarial Science Program...

Enterprise Risk Management

Shaun Wang, Ph.D., FCAS, ASADirector of Actuarial Science Program

Georgia State University

[email protected]

2004 C.A.S.E. Forum

Copyright by S. Wang, 2004 2

Outline

1. Concept of Risk

2. Inherent Risks for P&C insurers

3. ERM Approaches

4. ERM Education at GSU


ERM as a New Discipline

• High expectations & excitements!!

• ERM takes integrated approaches to major risks of an enterprise

• ERM represents new ways of understanding & managing risks

• ERM is a new and evolving discipline


Concept of Risk

1. Risk = Random “Volatility”

2. Risk = Not knowing reality (lack of info, driving in dark)

3. Risk = Wrong Existing Structure

Poor coordination & communication

Organizational cancer; needs structural reform!

4. Risk = Opportunity for the Prepared & Discerning


(I) Risk & Diversification

1. “Offset” produces the highest benefits:

long and short positions of the same asset

2. “Random drivers” offer good benefits

natural catastrophe events in various regions

3. “Expertise Intensive”: pooling across sectors may yield little or even negative risk diversification

Different market dynamics; different sets of expertise

4. “Drag effort”: legal or reputation spillover


Right and Wrong Diversifications

• Years of under-pricing were partially caused by the “low correlation” argument by some multi-line players

• Diversification needs to match with areas of expertise

Renaissance Re, a mono-line CAT-writer, achieves diversification by geographic region and by peril

• “ART” benefited buyers, but not sellers


(II) Risk & Information

• Quality and timeliness of information are critical for decision-making– Relative to their banking counterparts, many

insurers have poor grades on this

• ERM modeling needs forward-looking data

• Need aggregate risk info, as well as every way we want to look at the business


(III) Risk & Incentive Misalignment

• Many “risks” are created by misalignment of incentives

Underwriters short-term goal v.s. long-tailed liabilities

Managers’ expansion of his/her own kingdom

CEO’s compensation linked to growth and acquisition

• Trial Attorneys and the U.S. legal dynamics

Lawyer Contingent Fees & Punitive Damages


(IV) Risk & Valuation/Market Dynamics

• Risk often manifested in changes in value• Market participants can drive value changes

– Real estate bubble– Momentum investing– Portfolio insurance strategies– UK FSA experience

• Current versus Long-term Valuation– Pension funding deficit


Outline

1. Concept of Risk


3. ERM Approaches



100

150

200

250

89 90 91 92 93 94 95 96 97 98 99 00 01 02*

US Insured CAT Losses (in $billion) and Rate On Line Index (1989=100)

Source: Guy Carpenter & *III EstimateROL showed big jump after

major CAT losses, and then came down gradually …

$7.5

$2.7$4.7

$22.9

$5.5

$16.9

$8.3 $7.3

$2.6

$10.1$8.3

$4.3

$28.1

$5.8


Inherent Risks for P&C Insurers

• The infamous underwriting/reserving cycle– Independent from equity market risks– Not knowing final result for years– Lack of feedback on estimated reserves

• Hedging using reinsurance (within sector): high information asymmetry & transaction costs


S&P Report 19-Nov-2003Insurance Actuaries – A Crisis of Credibility

• S&P report: “Actuaries are signing off on reserves that turn out to be wildly inaccurate” …

• It sent a shockwave around the globe in the actuarial and insurance community!!

• American Academy of Actuaries countered 2 days after S&P release: “It is an obvious attempt to explain away the errors that some analysts have made in estimating property/casualty insurers’ earnings.”

• Both agree It is high-time for “Reserving Reformation”


$ Billions, Calendar Year Basis

$2.3 $2.2 $1.2

($8.5)

($1.5)

($7.5)($6.7)($10.0)

$22.7 $23

$0.3

($3.7)($0.3)

$9.9

($15)

($10)

($5)

$0

$5

$10

$15

$20

$25

90 91 92 93 94 95 96 97 98 99 00 01 02 03

P/C Insurance Industry Prior Year Reserve Development*

*Year 2003 number is an estimate by S&P.Source: A.M. Best, Morgan Stanley, Dowling & Partners Securities

$23 billion reserve increase = Hurricane Andrew

Reserve Cycle & Pricing Cycle are correlated


Reason for P/C Insolvencies (218 Insolvencies, 1993-2002)

Unidentified17%

Impaired Affiliate3%

Overstated Assets2%

Change in Business

3%

CAT Losses3%

Reinsurer Failure0%

Rapid Growth10%

Discontinued Ops8%

Alleged Fraud3%

Deficient Loss Reserves

51%

Source: A.M. Best, Insurance Information Institute

Reserve deficiencies account for

more than half of all p/c insurers

insolvencies


Cyclical Nature of Reserve Estimates

• The adequacy of reserve estimates showed a clear cycle over the years

• Reserve cycle coupled with the pricing UW cycle

Pressure on short-term performance

Following the competitors

Smoothing taxes for some players

A slow-death sentence for many companies


Outline

1. Concept of Risk


3. ERM Approaches



ERM Focuses on “Business Processes”

• Loss Modeling Is Only Part of the Story A company had the state-of-the-art actuarial pricing

model, but in the end still lost so much money

• Need to quantify the Business Process Risk

Top-line growth in a soft market poses a major risk

Over-crowded competitive market poses a major risk

• Need to enter the deep water by understanding the risk drivers and market dynamics


ERM Model of Market Competition

• Result = Min{Quote1, …, Quotek} Loss,

where Quotek Normal(k, k)

1. For long-tailed lines, delayed info higher k

higher chance of premium deficiency

2. more bidders k higher chance of premium deficiency

• The Winner’s Curse: In insurance competitive pricing, the lowest price gets the business, but may be cursed with financial losses


ERM Solution on Reserving: Contingent Payoffs

• Payoff contingent on magnitude of reserve development for a fixed block of business

• As deferred compensation (or tradable index)• Force decision-makers (managers, actuaries) to

put their money where their mouth is• Provide feedback channel for a block of business


Contingent Payoff Contract on Reserve Development

$(0.25)

$(0.20)

$(0.15)

$(0.10)

$(0.05)

$-

$0.05

$0.10

$0.15

-40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%

Future Reserve Development

Pay

off V

alue

PayOff

Tame U/W Cycle by financial engineering: Contingent payoff on reserve estimates


Outline

1. Concept of Risk


3. ERM Approaches



ERM Education at GSU

• Actuarial Education

– Scale back traditional components

– Go deeper and go wider

• Mathematical Risk Management

– Financial risk modeling and …

• Enterprise Risk Management


An actuarial/engineer approach

• Look risk as a “dynamics”

– Model each agent?

• External dynamics

– Financial risk modeling and …

• Internal dynamics

Q & A


DFA versus ERM

• DFA has not yet fulfilled its promises

– Did not focus on dominant risks

– Fancy stochastic model without benchmark parameters

– Weak organizational backing & poor communication

• How does ERM differ from DFA?

– ERM offers these missing elements for success


Did “U.S. Risk Based Capital” Help?

• U.S. Benchmark RBC has only limited success:

Factor based reserve charges ignored the bigger issue of reserve adequacy

Incentives for putting up inadequate reserves

Same capital charge factor for premium written in a hard market versus in a soft market

• A point-in-time measure, without reference to future direction and sensitivity over time


Opportunities for Creating Industry Benchmarks

• Industry benchmarks on risk parameters and capital charges are badly needed

• Benchmarks should reflect the inherent risks of the business, regardless of risk portfolio

• Parameters are more important than the model

• It will take much fundamental analysis, expert opinion, and timely updates

Extras

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Enterprise Risk Management Shaun Wang, Ph.D., FCAS, ASA Director of Actuarial Science Program...

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